Review your strategy . and portfolio

It's not every week we get a 1% cut in interest rates topped up with a $42 billion "stimulus" package. Now investors want to know: what difference will it make?

For investors there are some immediate effects: share investors will look towards building materials suppliers such as CSR  while residential property investors will take heart from a benevolent combination of lower rates and high rental yields.

Investors in retail stocks can also look forward to at least some temporary relief: retail stocks will surely benefit from this second stimulus package (the first was for $11 billion in November), retail figures released earlier today showed a powerful 3.8% jump in retail sales in December, the highest in eight years.

But for most investors the 1% cut in official cash rates, to 3.25%, is the most important development this week especially when you consider that inflation is still expected to be 2-2.5% and may rise in the future.

Rock bottom cash rates have important effects on investment choices; from a portfolio perspective, this week's changes have important implications for your cash holdings (as cash rates are affected) and your shareholdings (as earnings yields are affected).


The yield effect

The reality now is that the latest interest rate cut - and the expectation of more to follow - makes the yield on Australian shares look attractive.

With the market trading on a historical yield of just over 6%, with another 1.8% benefit for an investor from franking credits, even a 25% cut to the dividends from Australian shares would still see a total income (cash plus the benefits of franking credits) from share investments of about 5.85%. You have to view this figure against cash yields of around 3.25%.

For example, BHP, the biggest company on the Australian market today increased its half-yearly dividend by 41% to 41¢ a share. This takes its past 12 months of dividends to 83.6¢ a share, fully franked, for a gross dividend yield of about 4.1%.

And BHP is not traditionally a big dividend payer, that role is played by the banks. On Monday the Commonwealth Bank updated the market on its expectations of a net profit after tax of $2 billion. The bank's past 12 months of dividends has totalled $2.66 fully franked, or nearly a 9% income return on its current share price around $29.00. Including the value of franking credits improves this yield to more like 12%.

At the same time cash (and high-quality yield investments) still have a potentially important role in a portfolio by providing liquidity for investors (immediate access to funds), and dampening portfolio volatility.

One issue that investors need to be aware of in a period of low interest rates is to keep away from "snake oil salesmen" offering high-yield investment options. It was during the low interest rate environment early this decade that Westpoint and Fincorp style investments were started. The basic rule is simple: when the cash rate in the economy is 3.25%, investments offering higher rates than this have to be accompanied by higher risk. The temptation is to look for higher yielding investments but the risks of each investment must be thoroughly understood.

We are also fast approaching interest rate levels where it will be prudent for home owners and property investors to look at fixed rate mortgages. If cash rates fall towards 2% over the next few months (as many economists are suggesting), it provides an opportunity for people to lock in fixed rate mortgages at historically low levels. The "downside" issues that people should be aware of before doing this include understanding what ability there is to make extra mortgage repayments, and understanding what break costs there might be, for example, if you were to sell and pay out the mortgage before the end of the fixed rate period.

How can investors exploit the handouts?

The handouts are by definition for the less well off, but there are opportunities in the areas of co-contribution in super and also in salary sacrifice.

More than half of the people in Australia will receive lump sum handouts over the remainder of this financial year. It is an unprecedented cash handout by an Australian government, with average families reported as being $3800 better off. Handouts of $950 will go to workers earning less than $100,000 (with the $950 scaled back on incomes above $80,000), single income families, people qualifying for a training and learning bonus, low income families with children returning to school and those who qualify for a farmers' hardship bonus.

While the intention of the handout from the government perspective is to see it spent, at a personal level being strategic about this lump sum windfall might see its benefit magnified. Strategies with the money might include:

• If your income is above the level where you qualify for a government co-contribution, you can use the $950 bonus to meet your cost of living, and salary sacrifice the equivalent of $950 after tax to superannuation. For someone of an average income, this saves 16.5% in tax as income tax is 31.5% whereas the salary sacrifice to superannuation is only taxed at 15%. This strategy turns the $950 into $1107 for an average income earning - more if your tax rate is 41.5% or 46.5%.

• With these superannuation strategies keep in mind that you can't access your superannuation until preservation age - between 55 and 60, depending on your age. If you are worried about your shrinking superannuation balance keep in mind that you can almost always choose how you want your money invested (cash, shares, balanced, etc.) - so you could choose a cash option to be sure of preserving the value of your benefit.

• Pay off high interest debt. Credit card interest rates don't seem to have come down much with interest rates cuts, so if you have outstanding credit card debt a $950 "investment" on your cash can save you $171 in interest costs a year, as well as reducing your balance by $950. The benefit after three years is $1460.

• Build a cash reserve. With unemployment forecast to reach 7% be the end of next financial year, the bottom line is that we all have a greater chance of being unemployed for a period of time. You best ally for this is to have access to cash so the $950 can be used to start or add to your cash reserve, providing more confidence that you can cope with any difficult situation.
  

Don't ignore inflation even at these levels

There are various investment risks that have to be taken into consideration when putting together a financial strategy. An important risk is that of inflation risk: the risk that the funds you have will not keep pace with inflation. This risk is increased as people live further into retirement; a person retiring at age 60 has 30 years of lifestyle to fund if they live through to age 90. Over that time a 3% inflation rate reduces the purchasing power of cash by 2.5 times (meaning $100,000 will only buy the equivalent of $40,000 of goods and services in 30 years' time).

Treasury has forecast inflation of 2-2.5% over the next two financial years. In an environment where the cash rate is tipped to fall to these levels, cash effectively will do little more than keep pace with inflation.

Conclusion

Beyond the 1% cut in interest we got this week from the Reserve Bank, the government's latest stimulus package represents the equivalent of $2000 for every man, woman and child in Australia. As and investors you must now

• Recognise the falling income that cash like investments provide - likely to be well below the income from share investments going forward - while still using cash for liquidity and to dampen volatility within portfolios.
• Take care of seemingly attractive "high income" investment opportunities, which seem tempting against the low rate of cash on offer and which have often failed in the past.
• Be deliberate about the use of the $950 handouts, to look at combining them with a strategy like salary sacrificing to superannuation or the government superannuation co-contribution to increase the impact of the $950.
• Be aware of the increased likelihood of having some time out of work . and planning ahead by building a cash reserve to help get through that period.
• Be careful about the impact that inflation can have on cash-style investments over a long period of time.
• Take note of the areas of the economy directly impacted by the cash handouts, including retail and construction.
  

* (Ed Note (Feb 5) The Federal opposition has moved to block legislation which allow the Rudd government to introduce the 'stimulus package'. Though the legislation has now passed through the lower house, attempts will be made to adjust the legislation in the upper house. As a result, some aspects of the stimulus package as originally presented by the Rudd government on Feb 3 may change in the coming weeks.